Cooper Tire and Rubber’s business is extremely complicated: they make tires. Their main competitors are Goodyear and Bridgestone. They manufacture and sell tires throughout the world. They operate in a highly competitive market with a commoditized product. Their business model is also impacted by the secular trend of the decline in domestic car driving (increasing use of things like ride sharing and Uber). The company could also be impacted by political headwinds. The Trump administration’s protectionist stance could impact tires that the company produces overseas and sell in the United States. At the same time, Trump’s desire to repeal the Affordable Care Act could help the company. It’s a mixed bag and it isn’t a particularly exciting business.

Sentiment

Year to date the stock is down 12.61% and it trades at an earnings yield of 11%. It is an unexciting company is a competitive, commoditized business and hasn’t participated in the bull run for stocks in the last year. The market doesn’t hate it, but it is indifferent to it.

My take

Despite the business pressures, the stock is cheap and the company is aggressively returning capital to shareholders. In the last five years, the number of common shares has been reduced by 18%. The balance sheet is clean with a low debt/equity and low debt/EBITDA. The clean balance sheet combined with the attractive valuation means that shares will continuously be repurchased at an attractive valuation.

Despite the competitive nature of the business, the company consistently generates stable free cash flow. This will give it the cash necessary to sustain the share buybacks. Return on equity and assets is low, but this isn’t a bad thing because no one in corporate America is saying: “Hey guys, let’s enter the tire business!”

Additionally, I think the sentiment about the secular decline of driving is overblown. While the growth rate has flattened since the Great Recession, the number of miles driven by Americans is not in decline. The total miles driven by Americans recently hit an all-time high of 3,193,010 in 2017. That’s a lot of driving and a lot of tires getting worn out and in need of replacement.

Foot Locker is known to everyone that has ever been in a mall. They are a physical retailer and operate primarily in malls selling sneakers. They also sell footwear directly to customers.

Sentiment

Market sentiment against the stock is extremely negative. Year to date the stock is down 42.42%. This is even after a monstrous 28% gain on November 17th after delivering an earnings surprise. The extreme sentiment against the stock is due to the fact that it is a retailer and most of its locations are in malls. The sharp change in sentiment has been rapid. As recently as May 2017, the stock was hitting all-time highs.

My take

The sentiment against mall retail has been extreme and the popular perception is that Amazon is going to dominate everything. Overall, I think this is overblown. 90% of all retail sales still occur in a store. E-sales have been increasing at a steady pace of about 1% a year since the year 2000. The trend hasn’t changed. This means that in 10 years, 80% of all retail sales will still occur in a store. The popular sentiment has driven retail stocks down to depths not seen since the Great Recession and the ridiculous multiples given to Amazon shows that the market sentiment is now at extreme levels.

Not only will people continue to shop in stores for the customer experience, they will continue to shop in apparel stores like Foot Locker because they want to try the apparel on. Sneakers from different manufacturers aren’t consistent and most people want to try the shoe on in the store.

The company consistently produces ample free cash flow each year and they have been using the proceeds to grow the business and return capital to shareholders. Common shares have declined by 9% in the last five years as the company consistently repurchases shares. Additionally, the dividend yield is 3.04%. The company’s balance sheet is also extremely strong, with extremely low debt levels.

Foot Locker also possesses an important strategic relationship with Nike, which remains the leader in sneaker brands. This is a situation where bad sentiment has caused investors to throw the baby out with the bathwater.

Gamestop is a video game retailer. They sell video games and the hardware associated with it. They’re the largest retailer of pre-owned video game products in the world and carry a broad selection of all generations of video game consoles. They have a variety of loyalty programs in an attempt to connect with and keep customers.

Sentiment

With the growth of online gaming and video games increasingly delivered in digital form, sentiment against Gamestop is extremely negative. The perception is that due to Gamestop’s reliance on pre-owned video games and sales of new video games being delivered digitally, it is a diminishing market that is in a state of decline. Year to date the stock is down 35% and the current price of $16.31 is close to its 52-week low of $15.85.

My take

Despite the challenges, Gamestop has continued to deliver strong operating results. While top-line revenues have declined, the company has been able to improve gross profits. They have also been using their revenues from their dying (but highly profitable) business to return capital to shareholders in the form of a large dividend yield and stock buyback. The new video game console (the Nintendo Switch) should help deliver better results this holiday season.

With a P/E of 4.91, the sentiment is extremely negative against Gamestop. This is due to the fears that physical retail of gaming is a business that is destined for death. The low valuation is also due to a double whammy of hatred: they have physical retail stores and they have lots of locations in malls.

Gamestop is fighting the decline by adopting a subscription-based video game rental service for $60/month. Gamers can borrow as many games as they want from the physical store. They’re also using the cash flow from their declining (but highly profitable) used games business to return capital to shareholders. Gamestop is returning capital to shareholders in the form of dividends and buybacks. Common shares have declined by 2.59% in the last year and the dividend yield is currently 9.32%. Gamestop’s low debt/equity and low debt/EBITDA give it the balance sheet strength to pursue a turnaround strategy and continue the large return of capital to shareholders in the form of dividends and buybacks.

December is for the holidays. Warm fires, quality time with family, generosity, cookies, gift giving and . . . Rebalancing my portfolio and buying hated assets!

Why do I want to rebalance in December?

Give cheap stocks a chance – I want to give my investments at least a year to work out.

Time is not on my side – I buy stocks of the “deep value” variety. These are companies that are in trouble. I believe if there is not a problem with a stock, then there can’t really be any value. I think that cheap stocks without any hair on them are about as rare as unicorns. These are not Warren Buffett value stocks that are long-term compounders with a moat and high returns on capital that I can stay invested in for decades. I’m not “picking winners,” I’m buying mispriced stocks and selling when they reach their intrinsic value. As a result, time is not on my side. As Warren Buffett says, time is the friend of the good business and the enemy of the bad business. I have to continuously move into and out of cheap stocks as their valuations change.

Momentum – Once a cheap stock gathers some momentum, I want to ride it as long as it lasts. Quarterly rebalancing can cut off momentum as soon as the situation gets fun. Quarterly rebalancing also increases transaction costs, which I’m trying to minimize as they’re already high.

The December Effect – I am shamelessly taking advantage of what academics call the January effect. Academics notice that stocks tend to do very well in January. They assert that this is due to investors selling their losers in December for tax purposes and then piling back in come January. I prefer to call it the “December Effect” because it is a time of the year that momentum takes over. Cheap stocks get cheaper and hot stocks get more expensive. This creates opportunities for value investors. There is the tax loss effect, but there is more to it than that. In one of Peter Lynch’s books (I don’t have it handy, but I believe it’s in One Up on Wall Street), he explained that December is a time of year that portfolio managers do significant clean up going into year end. A professional portfolio manager doesn’t want to go to his boss, consultants and investors with a bunch of “garbage” in his portfolio (i.e., the kind of stocks that I like to buy). They want to buy cool stuff that will get their superiors and investors excited — i.e., whatever has gone up this year (FANG, Tesla, maybe a dash of cryptocurrency for dramatic effect). This tends to make value stocks even cheaper in December, creating a great opportunity to buy them.

Will this just get arbed away? – The December/January effect will probably get arbitraged away eventually. Then again, it was identified in the 1980s, and it still works to this day. Even if it stops working, I still need to rebalance annually, and I might as well pick the time of the year that has been historically most advantageous to do that. December it is.

Die Hard: The Finest Christmas Movie

The Candidates

With the bull market now raging for nearly a decade, the number of cheap stocks is rapidly decreasing. Most of the value in this market is concentrated in retail. While I am okay with taking a huge (i.e., 30-40%) position in one industry that is struggling and hated, I am not going to invest 60-80% of my portfolio in it. That is far too much for my taste. If I were to buy all the statistically cheap stocks out there, most of my portfolio would be in the retail sector.

To prevent this, I moved 20% of my portfolio into international indexes at attractive valuations. The purpose of this was to diminish my concentration in retail stocks and reduce my exposure to a heated US market. If the US market falls next year and increases the value opportunity, I’ll sell these indexes and buy more US companies at attractive valuations in a diversified group of industries.

Here are the candidates I am considering:

Current positions I will likely keep and expand:

Cooper Tire & Rubber (CTB)

Gamestop (GME)

Foot Locker (FL)

New Retail Positions:

Big 5 Sporting Goods Company (BGFV)

Francesca’s Holding Corp (FRAN)

Hibbett Sports (HIBB)

Dick’s Sporting Goods (DKS)

Chico’s (CHS)

Gap (GPS)

New Insurance Positions:

Genworth Financial (GNW)

American Equity Investment (AEL)

New Assorted Positions:

Interdigital (IDCC) – Tech

United Therapeutics (UTHR) – Biotech

Tredegar (TG) – Chemicals

Reliance Steel & Aluminum (RS) – Materials

Pendrell Corp (PCO) – Sub-liquidation value and net cash

Tennis Shoes

I am considering more concentration into 10-15 stocks instead of 20.

Most people will say this is a terrible idea. Graham recommended 20-30 stocks. That’s also what Greenblatt recommends in The Little Book that Beats the Market. The academics also seem to agree that 20-30 is the ideal portfolio size.

I recently read Concentrated Investing, a series of excellent stories about famous investors (Buffett, John Maynard Keynes, Lou Simpson, Charlie Munger) who ran very concentrated portfolios. One funny story from the book involves a conversation with Arthur Ross, who explained the secret to his success as “tennis shoes.” This was a misinterpretation: he actually said “ten issues.” He owned only ten stocks at any given time. Most of the investors featured in the book had great success with this kind of concentration.

Joel Greenblatt was also successful with concentrated investing in the 1980s and 1990s when he maintained a portfolio with as few as 8 names.

Concentration is a great tool to increase returns. Alternatively, it should also increase losses and drawdowns. It increases the volatility of the portfolio. Of course, as a value investor, I don’t consider volatility to be a risk.

In fact, looking at my dismal performance over the last year, I think a lot of it had to do with the fact that I filled my portfolio with additional stocks for the sole reason of hitting a 20-stock goal. The general underperformance of value hurt my performance, but I think that diluting my best ideas also played a big role.

Even with the big assists in my “low confidence” portfolio from TopBuild and Supreme Industries, my best 10 ideas outperformed my worst. This is even with some highly prominent duds in my top 10 stocks, with CATO being the biggest. For this reason, I think it might make sense to concentrate on my top 10 ideas.

My primary concern with a portfolio isn’t volatility, it’s maximum drawdowns. I did a bit of backtesting and research to determine the kind of maximum drawdowns I could expect from a concentrated portfolio.

I performed a backtest on the lowest EV/EBIT names. A portfolio of 10 stocks had a max drawdown of 62.48%. A portfolio of 20 only lowered it slightly to 62.04%. More stocks didn’t bring much to the party.

I also took a look at Validea’s value investment screen. Their 10-stock screen has delivered a 12.6% rate of return since 2003 with a 2008 drawdown of 27.2%. The 20-stock variation achieved a 9.2% rate of return with a 2008 drawdown of 31.5%. In other words, the portfolio with more stocks decreased returns and increased drawdowns.

The results are similar for their price to sales screen. The 20 stock screen delivered a return of 8.9% with a 2008 drawdown of 39.4%. The 10 stock variation returned 9.8% with a 25.1% drawdown in 2008. Same result: more stocks increased the bear market drawdown and lowered overall returns.

Stockopedia has a handy chart showing the number of stocks and volatility versus the index. Once you get up to 10 stocks, most of the volatility is meaningfully reduced. To get the major benefits of diversification after owning 10 stocks, you have to get up to 50 stocks. At that point – why are you even bothering owning individual stocks? You might as well buy a fund or ETF with a style that you agree with.

I see a similar pattern with Alpha Architect’s backtest of the simple Ben Graham screen (low P/E, low debt/equity, which is very similar to my own strategy). In 2008, the 15 stock portfolio went down 27.78%, 20 stocks went down 29.38%, 25 stocks went down 30.88%. More stocks did nothing to reduce the severity of the drawdown. The results were similar for other big drawdowns in value stocks: 1990, 1998, 1974. All of the portfolios held up roughly the same in each drawdown, with the 15 stock variation usually holding up better.

Theoretically, a bigger portfolio should reduce returns, but also reduce the severity of drawdowns. That doesn’t seem to happen in practice.

A big portfolio does little more than reduce volatility while increasing drawdowns and lowering returns. It’s almost as if more stocks only provides the illusion of safety. The risk that I actually care about, lowering drawdowns, doesn’t seem to be impacted at all by the number of stocks held in a portfolio.

This is a point Greenblatt makes in his earlier book, You Can Be a Stock Market Genius. He points out that most of the benefits of diversification can be achieved by owning only 10 stocks. He makes the following point:

“Statistics say the chance of any year’s return [for the entire market] falling between -8% and +28% are about two out of three . . . these statistics hold for portfolios containing 50 to 500 different companies . . .What do statistics say you can expect, though, if your portfolio is limited to only five securities? The range of expected returns in any one year really must be immense . . . The answer is that there is an approximately two-out-of-three chance that your portfolio will fall in a range of -11 percent to +31 percent. The expected return of the portfolio still remains 10 percent. If there are eight stocks in your portfolio, the range narrows a little further, to -10 percent to +30 percent. Not a significant difference from owning 500 stocks.”

Joel further elaborates:

“The fact that this highly selective process may leave you with only a handful of positions that fit your strict criteria shouldn’t be a problem. The penalty you pay for having a focused portfolio – a slight increase in potential annual volatility – should be far outweighed by your increased long term returns.”

Style Considerations

A concentrated portfolio is unusual for a deep value investor. Graham owned lots of stocks. I believe he held over 100 net-nets at one point. Walter Schloss also owned a high number of stocks.

The investors who ran concentrated portfolios successfully (Buffett, Munger, Lou Simpson) were those who emphasized quality businesses and long-term positions. It’s one thing to put 10% of your portfolio into Coca-Cola. It’s entirely different to do it with a money-losing, terrifying net current asset value stock, for instance.

It’s highly unusual for a deep value investor to take such a focused approach. You’re dealing with businesses going through difficult times, and it can be somewhat frightening to some investors to have a concentrated, often volatile, position in these stocks.

In any case, if I do pursue more concentration, it would be a highly unusual move for someone with my outlook. If I do it, I’m going to have to make sure I do significantly more homework. I’m also going to have to make sure that I am diversified across different industries. I’m not going to buy 10 retail stocks, for instance (as tempting as that is right now).

Summary

My portfolio will be rebalanced every December. Annual rebalancing is my preference and December is the best time to do that due to tax loss selling and professionals “cleaning up” their portfolio for cosmetic reasons.

I noticed that my 10 best ideas outperformed my 10 worst.

Due to this, I’m considering concentrating my stock portfolio on only 10-15 stocks.

Looking at quant value screens, additional stocks only reduce volatility, but they don’t reduce max drawdowns which is what I actually care about.

Concentration is unusual for deep value investors.

If I do concentrate on 10 names, I need to make sure that they are diversified across different industries.

Disclaimers

To reiterate — I am not a professional. I am just a guy with a brokerage account and a blog. I’m taking risks that many smart people say I shouldn’t be taking.

This blog may go down in internet history as “crazy man proves that you should shut up and give your money to an index fund.”

It would break my heart if someone out there took my stock suggestions and lost money. So, please, do not emulate what I’m doing here. The purpose of this blog is to force me to record what I’m thinking (something that we often forget with the benefit of hindsight), to keep me honest (i.e., I hope you all send me scathing comments and emails if I do something whacky like buy Tesla stock or a cryptocurrency). Do your own homework, do your own analysis, get plenty of advice, and choose an investment approach that’s right for you.

Recapping the last few blog posts: I think valuations are too high in the United States. Choose your poison: CAPE ratios, market cap to GDP, or the average investor allocation to equities. All suggest low returns in the coming decade.

At the same time, I know that attempting to time the US market using valuation is a fruitless effort. Markets can stay expensive for a long time. Since 2000, the US market has only gone to its “average” historical valuation once, in the depths of the 2009 financial crisis. Avoiding the market for a long time in a low return asset like cash or t-bills ultimately hurts future returns. It can even result in negative real returns if inflation picks up. If interest rates stay this low, then the market can certainly remain expensive. The direction of interest rates is the key question when determining future valuations.

For value investors, timing based on the valuation of the broader market is particularly tricky because there is often value in individual securities even if the broader market is overvalued. For instance, in the early 2000s, value stocks had a nice bull market while the broader market melted down. In Japan, while the broader market was crushed, Joel Greenblatt’s magic formula returned an amazing 18% annual rate of return from 1993-2006.

So, I think that a portfolio of 20-30 cheap stocks over the next 10 years will handily beat the S&P 500.

The caveats to this:

(1) Value doesn’t usually experience a bull market while everything else goes down. The only time this happened was the early 2000s. Value stocks normally go down with everything else. I suspect the current disconnect between value and growth stocks will see value triumphant, but we likely won’t see that happen until a decline happens in the broader market.

I suspect the current cycle will be more like the 1970s when value stocks went down with the broader market in 1973 and 1974 and then staged a very nice bull market after ’74.

The current cycle has much more in common with the early ’70s than it does with the late 1990s. The high flying stocks of the early ’70s weren’t crazy speculative companies like they were in the late ’90s. The hot stocks of the ’70s weren’t garbage like Pets.com, they were quality companies like McDonalds and Xerox. It’s the same thing today. The high valuations aren’t in junky speculative companies, they are in quality names like Facebook and Amazon.

The decline of 1973-74 wasn’t driven by a bubble popping like 2000, it was caused by a macro event (the oil crisis), which brought down the richly valued companies by bigger drawdowns than everything else. I think the same thing will probably happen to the US market this time around. What event will cause this is unpredictable (a war with North Korea, inflation causing a hike in interest rates?), but I think something is likely to come along that will cause a major drawdown.

A smart guy like Nassim Taleb would call this a “black swan” or “tail risk” event. I prefer a simpler way to express this: shit happens.

(2) Trying to time the US market with CAPE ratios is ineffective. The alternatives (cash, T-bills) do not yield enough to justify moving in and out of the US market. Tobias Carlisle did some great research on this here.

(3) Even value stocks are expensive in this market. For instance, a stock screen I like to comb through is the number of stocks trading at an EV/EBIT of less than 5. Out of the entire Russell 3000, I can only find 16 of them outside of the financial sector. Of these, half of them are in the retail sector.

At the beginning of 1999, there were 38 of these opportunities in a diversified group of industries. After the manic tech euphoria of 1999 where money flowed from “boring” stocks into tech, the number grew to 70 at the start of 2000. This group of stocks returned 20% in 2000, while the S&P 500 went down by 10.50%.

Expensive Value Stocks

The value opportunity set in the United States is currently limited.

Much of what fueled the early 2000s bull market in value stocks was the wide availability of cheap stocks in diverse industries. This simply isn’t the case today, as the small number of value opportunities in the U.S. is concentrated in one industry: retail.

I currently have 30% of my portfolio invested in the retail sector, which I’m comfortable with. If I were to buy all the cheap stocks in the United States, over 60% of my portfolio would be invested in retail. While I think retail stocks will ultimately stage a resurgence, I’m not certain of it. A 60-80% concentration in one industry is too risky. The sector could easily be cut in half again. 30% is the maximum extent that I am willing to commit to an individual industry. If retail were cut in half, my potential loss if 15% of my portfolio. If I expanded that to 60% or 80%, I could lose 30-40% of my entire portfolio. That’s a much more difficult event to recover from.

I could achieve more diversification by taking a relative valuation mindset to the current market, but I think this is dangerous. I prefer absolute measures of valuation — like a P/Sales of less than 1, the price is below tangible book, EV/EBIT of less than 5, 66% of net current asset value, earnings yields that double corporate bonds, etc.

A major reason I prefer absolute measures of valuation is that I think high valuation ratios in the cheapest decile of a market is a sign that the valuation metric is losing its effectiveness. A good example of this is price/book.

Price/book worked marvelously prior to the 1990s, but its effectiveness has been dramatically reduced since then. This is because Fama & French identified price/book as the best value factor. This made it respectable to buy low price/book stocks, while previously low price/book investors were regarded as oddballs (rich oddballs who consistently beat the market, like Walter Schloss!). Once Fama & French gave it their blessing, vast amounts of institutional money poured into low price/book strategies. Price/book became synonymous with value and this ruined the effectiveness of the factor.

If too much money chases low P/E, P/Sales, EV/EBIT stocks, then they will suffer the same fate as price/book. They will still work due to human nature (investors will always find ridiculously cheap stocks repulsive), but the effectiveness will be diminished. Institutional big money can ruin the factor. I think a good way to tell that this is happening is to focus on absolute metrics of valuation rather than relative valuation compared to the rest of the market. If too much money chases the value factor, then absolute measures of valuation will rise. By focusing on absolute levels of valuation, I can avoid this.

EV/EBIT is by far the best of all value factors, but if too much money chases it, the effectiveness will be reduced.

This is why I think focusing on absolute valuation is a way to prevent falling into this trap. Think about it through the prism of the real estate bubble: a house cheaper than the rest of the neighborhood was still a bad bet in 2006 because all real estate was in an inflated bubble. A single house might have been a good relative value and suffered less of a price decline than everything else, but it was still expensive. Focusing on an absolute level of valuation would have helped avoid this trap.

Going International

The beauty of the modern world is that I’m not limited to the United States. Previous generations of investors had a handful of options: cash, bonds, US stocks. Fortunately, I don’t have to sit on a pile of cash earning nothing while I wait for US markets to deliver me juicy opportunities, which is a bad strategy that can cause real inflation-adjusted losses the longer that the adjustment takes. I could wind up sitting on cash for a decade, absolutely decimating my real returns.

A great alternative to cash while the US market is expensive is investing internationally. While I don’t trust my ability to research foreign companies, I am comfortable investing in an index of a foreign country. While I think foreign stocks are more prone to fraud, I don’t think the financial results of an entire index can be fraudulent.

A few weeks ago, I did this in a very crude way. I invested 10% of my portfolio into a basket of the 5 cheapest country indexes on Earth.

If I’m going to do this in a bigger way, I need a better quality metric. It seems obvious to me that higher quality countries (like the United States) should command a higher valuation than a low-quality country. The definition of a bargain would also depend on the economic quality of that country. For instance, the US at a CAPE Ratio of 15 (where it was in 2009) is a screaming bargain, while Russia at a CAPE of 15 is probably a bit expensive in comparison to the risk. I’ll invest in a country of any quality – but I should demand a higher margin of safety if it is a low-quality country.

But how does one measure the “quality” of an entire country? This is a tough thing to quantify. Mainstream economists do this by splitting up the “developed” (i.e., already rich) parts of the world from “emerging” (trying to get rich) and “frontier” (poor). This doesn’t make sense to me to use as a quality metric. An emerging or frontier market may have better prospects than a developed, rich country.

What makes a country’s economy “quality”?

One of my favorite books about this subject is P.J. O’Rourke’s “Eat the Rich“. P.J. has written some of my favorite books of all time (Parliament of Whoresin particular).

In the book, P.J. tries to define what makes countries “good” economically. His question is pretty simple: “Why do some places prosper and thrive, while others just suck?”

P.J. explains the conundrum in the following passage:

It’s not a matter of brains. No part of the earth (with the possible exception of Brentwood) is dumber than Beverly Hills, and the residents are wading in gravy. In Russia, meanwhile, where chess is a spectator sport, they’re boiling stones for soup. Nor can education be the reason. Fourth graders in the American school system know what a condom is but aren’t sure about 9 x 7. Natural resources aren’t the answer. Africa has diamonds, gold, uranium, you name it. Scandinavia has little and is frozen besides. Maybe culture is the key, but wealthy regions such as the local mall are famous for lacking it.

Perhaps the good life’s secret lies in civilization. The Chinese had an ancient and sophisticated civilization when my relatives were hunkering naked in trees. (Admittedly that was last week, but they’d been drinking.) In 1000 B.C., when Europeans were barely using metal to hit each other over the head, the Zhou dynasty Chinese were casting ornate wine vessels big enough to take a bath in–something else no contemporary European had done. Yet, today, China stinks.

Government does not cause affluence. Citizens of totalitarian countries have plenty of government and nothing of anything else. And absence of government doesn’t work, either. For a million years mankind had no government at all, and everyone’s relatives were naked in trees. Plain hard work is not the source of plenty. The poorer people are, the plainer and harder is the work that they do. The better-off play golf. And technology provides no guarantee of creature comforts. The most wretched locales in the world are well-supplied with complex and up-to-date technology–in the form of weapons.

You should read the whole book (it’s really funny), but the gist is pretty simple: what causes prosperity is economic freedom. Economic freedom doesn’t just mean “people can do whatever they want”, it is capitalism within a defined rule of law that is enforced.

The magic ingredient that can make a country rich is economic freedom, and it’s what turned the United States from a third world nation of farmers into the richest country on Earth that it is today over a relatively short span of history. The people of the United States weren’t more talented or better than anyone else. We were the first to wholeheartedly embrace capitalism while the rest of the world fiddled around with bad ideas like feudalism, mercantilism, socialism, and communism.

The secret to US success is now out.

Since the fall of the Berlin Wall in 1989, economic freedom has been advancing throughout the world (even though it has retreated in its birthplace, the United States). The worldwide spread of capitalism and economic freedom have been profoundly positive for humanity. In fact, the global rate of poverty has been cut in half since 1990. It’s not a coincidence that this decline began at the exact moment that the Soviet Union collapsed. As the world embraces capitalism, it is growing increasingly prosperous as a result.

If we acknowledge that economic freedom is the best measure of the “quality” of a country, how do we quantify that?

The Index of Economic Freedom

The Heritage Foundation has done the world a service by quantifying economic freedom in their index of economic freedom, which they update annually.

Each category is scored and the total is grouped in the following levels:

Free: 100-80 (Australia, Hong Kong, Singapore)

Mostly Free: 79.9-70 (The United States, Ireland, the UK, Sweden)

Moderately Free: 69.9-60 (Israel, Japan, Mexico, Turkey)

Mostly Unfree: 59.5-50 (Russia, Egypt, Iran, China)

Repressed: 49.9-40 (Venezuela, North Korea, Cuba, Afghanistan)

Going forward, I think I will buy “free” and “mostly free” countries (a score of 70-100) if their CAPE Ratio is below 15. By this metric, Singapore is the most attractive market in the world right now, with a CAPE ratio of 12.9 against an economic freedom score of 88.6.

If I’m going to buy countries that are “mostly unfree”, I should demand a higher margin of safety — i.e., it should be a compelling bargain, with a CAPE ratio below 10. Russia would be defined as “mostly unfree” (Russia currently has a score of 57.1). However, at Russia’s current CAPE ratio of 5.6, it would still meet my requirements and provide an adequate margin of safety.

The quick and dirty way I think about P/E ratios or CAPE ratios is in terms of earnings yield. Take the P/E or CAPE ratio and divide it with 1. For instance, Russia’s CAPE is 5.6, so its earnings yield (1/5.6) is an astounding 17.85%, well worth the heightened risk of owning that country’s stocks. The US, with a CAPE ratio of 30, would have an earnings yield of 3.33%. This means US investors can expect a total return of about 34% in the coming decade. In comparison, if Russia delivers a compounded return of 17.85%, it’s a return of 438%.

It’s also important to consider that the returns will be lumpy. Much of the return could be concentrated in a few years and there will likely be a large drawdown at some point. Stocks deliver high returns because of these drawdowns. The high returns of stocks are a compensation for this risk. The US returns aren’t terrible, especially when compared to bonds, but they’re nothing to get excited about.

Among the other two positions I chose, Poland and Turkey, they are in the murkier area of “moderately free”. I think I’ll buy these type of markets when they get below a CAPE ratio of 12.

Here is where my current positions stack up in terms of both CAPE ratio and standings in the index of economic freedom:

Using these guidelines, I made a good choice with both Singapore and Russia, but likely paid too much for Brazil and Poland. As I expand my position in international indexes while the US market is expensive, I will use the index of economic freedom as a rough quality metric when determining the appropriate price to pay for each country.

When I rebalance my portfolio in December, I am going to expand this segment of my portfolio. When the US market suffers a drawdown, I will reduce this segment of my portfolio and purchase more bargain stocks boasting low absolute valuation metrics.